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Don't Miss This Cheap Stock

Here's how you avoid a value trap.

The problem is that "cheap" is a relative term. Precious few stocks that trade for low price-to-earnings ratios or below book value are real bargains. They look enticing, but are instead value traps -- stocks that deserve the multiples for which they trade, and punish the dumpster divers who buy them.

But don't take my word for it. Here are five "cheap" stocks that trapped bargain-hunting prey:

Watch out!How can you avoid value traps like these? My favorite method is borrowed from professor Aswath Damordaran, author of Investment Fables. In it, he counsels investors to measure low price-to-book stocks by their returns on equity (ROE).

Makes sense to me. Book value is shorthand for equity. A low price-to-book stock is priced as if management won't produce high returns from the equity capital afforded it. Find a stock that defies this maxim -- a stock with an above-average and rising ROE -- and you may have found a bargain.

A machete for when you're in the weedsOur 125,000-member-strong Motley Fool CAPS database is a great place to start your search. I ran a screen for well-respected stocks trading for less than twice book value, and whose returns on equity were 10% or more. As a qualifier, the candidates also had to trade no more than 25% above their 52-week low, leaving plenty of room for further gains.

Of the 176 stocks that CAPS found hiding in the weeds, Allied Irish Banks(NYSE:AIB) intrigues me most this week. The details:

But it may also prove too good to be true. If the current financial crisis has taught us anything, it's that banks such as Citigroup(NYSE:C) can lose equity just as fast as they earn it -- especially if the value of the equity-producing assets, the ones responsible for Allied Irish's super-low price-to-book ratio, are overstated.

I hate banks and financial services. I shorted many of the regional banks about a year ago with much success. I am not in favor of the bailouts which appear to be used both in the US and Europe to purchase additional deposits rather than increase liquidity. That having been said, this pick is a no brainer. Ireland may be the soundest economy in Europe. Other than Lloyds and National Bank of Greece, this company has the best management with a conservative track record and holds little, if any bad paper.

Allied Irish might not have much bad paper, but that didn't stop the Irish government from stepping in. It forced Allied Irish to take 2 billion euros of capital, in return for preferred stock paying 8% interest. That will have to be paid before any dividends can reach common shareholders. Thus, the question remains: Will Allied Irish be able (and willing) to pay its dividend in 2009?

What do you think? Is Allied Irish Banks the bargain it appears to be, or a value trap waiting to snap? Let us know by signing up for CAPS today. It's 100% free to participate.

See you back here next week with more bargain-basement Foolishness.

Beginning Jan. 12, 2009, Fool co-founder David Gardner, Jeff Fischer, and their Motley Fool Pro team will accept new subscribers to their real-money portfolio service. Motley Fool Pro is investing $1 million of the Fool's own money in long and short positions in a range of securities, including common stocks, put and call options, and exchange-traded funds (ETFs). They also incorporate proprietary CAPS "community intelligence" data into their research. To learn more about Motley Fool Pro and to receive a private invitation to join, simply enter your email address in the box below.

Author

Tim Beyers first began writing for the Fool in 2003. Today, he's an analyst for Motley Fool Rule Breakers and Motley Fool Supernova. At Fool.com, he covers disruptive ideas in technology and entertainment. Find him online at timbeyers.me or send email to tbeyers@foolcontractors.com. For more insights, follow Tim on Twitter.